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April 27, 2011

The Pitfalls for You and Your Client When They Take Your Tax Advice

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Every advisor is going to discuss tax issues with his or her clients. It’s inevitable given the tax benefits (and pitfalls) of investments and insurance and other planning issues. Everyone in the financial services business knows that nitty-gritty tax advice should be delegated to the client’s CPA or attorney. But some advisors forget that truism and stray into dangerous territory, offering tax advice to their clients. Then, when the IRS comes knocking at the client’s door, the first person the client calls will be the advisor who gave them the advice.

If the advisor wears another hat, being a licensed attorney or CPA, the client may be able to avoid penalties based on their reliance on their advisor’s tax advice. But to avoid penalties, reliance on the advisor’s advice must have been reasonable—the client can’t ignore the facts in front of their face. Reasonableness, however, can be hard to prove, as illustrated by the recent U.S. Tax Court decision in Pamela B. Russell v. Commissioner (T.C. Memo 2011-81 (2011)).

The Facts in the Case

Mrs. Russell handled her family’s daily expenses; her husband handled everything else. In the 1990s, her husband began working with Mr. Bagdis, a financial advisor and tax attorney. Mr. Bagdis provided the couple with reliable tax advice – until 2002.

In 1999, Mr. Bagdis advised the couple not to file their joint tax return until he could calculate the exact losses that the husband’s business suffered during the taxable year. The couple followed his advice and received a tax refund once they filed the return. Mr. Bagdis gave the Russells similar advice in subsequent years.

In 2002, Mr. Bagdis advised Mrs. Russell not to file her 2001 return when it was due; again, she followed his advice. Eventually, her failure to file resulted in Mrs. Russell receiving delinquency notices. IRS agents then subpoenaed Mrs. Russell for records and seized files from her husband’s office. By 2005, the couple retained new counsel, who helped them through the process of properly filing their delinquent tax return.

What Constitutes Unreasonable Reliance?

Taxpayers are required to file returns and pay taxes by the specified tax deadline; they can submit amended returns if necessary. Taxpayers who fail to timely file and pay their taxes are subject to paying additional taxes. Thus the unavailability of all requisite information is no defense to liability for

tax penalties. Courts can penalize taxpayers even if they didn’t underpay their taxes on purpose.

Exceptions are made if the taxpayer can show that the failure was due to reasonable cause, which is measured by an “ordinary business care and prudence” standard. This means that another person in a similar situation would have acted the same way. However, if the Court finds that the taxpayer acted unreasonably, then the taxpayer must prove that his or her failure to timely file the tax return was not due to carelessness, reckless indifference, or intentional failure.

Mrs. Russell claimed that she was advised to wait for Mr. Bagdis to complete the return, albeit late, to avoid signing a fraudulent return and perjuring herself. She relied on her advisor’s advice that she would be owed a refund for 2001 and thus wouldn’t be penalized for filing a late return. Unfortunately for Mrs. Russell, the Court believed that Mrs. Russell’s reliance on Mr. Bagdis’s assertion respecting her tax liability was unreasonable and penalized Mrs. Russell for failing to timely file and pay the couple’s 2001 tax return.

The lessons of the Russells are simple. First, clients need to secure the services of a competent tax advisor. Second, they shouldn’t blindly rely on the information they receive from them. If something doesn’t seem right, they should seek a second opinion or information from additional sources. Reliance on a tax advisor’s advice will only save them from penalties if relying on the advice was reasonable.